Published: November 01, 2013
The EACT has published a position statement commenting on the European Commission's proposed Money Market Funds regulation. The EACT argues that for the real economy there is one fundamental flaw in the proposal - the bar on the use of external credit ratings. The EU’s intention to require CNAV funds to hold a capital buffer is also highlighted as a measure that is likely to make the CNAV product unviable; the EACT proposes instead improvements in disclosure and the use of liquidity gates and fees, the combination of all of which would better support the real economy than introducing capital buffers.
The EACT argues that for the real economy there is one fundamental flaw in the proposal - the bar on the use of external credit ratings. The EU's intention to require CNAV funds to hold a capital buffer is also highlighted as a measure that is likely to make the CNAV product unviable; the EACT proposes instead improvements in disclosure and the use of liquidity gates and fees, the combination of all of which would better support the real economy than introducing capital buffers.
The EACT is a grouping of national associations representing treasury and finance professionals in 18 countries of the European Union. We bring together about 12,000 members representing 6,500 groups/companies located in the EU. We comment to the European authorities, national governments, regulators and standard-setters on issues faced by treasury and finance professionals across Europe.
We seek to encourage the profession of treasury, corporate finance and risk management, promoting the value of treasury skills through best practice and education.
This document is on the record and may be freely quoted or reproduced with acknowledgement.
The EACT notes the publication by the European Commission of a Proposal for a Regulation on Money Market Funds (MMFs) on 4 September 2013.
The EACT understands the Commission’s aim of ensuring financial stability and the concern that some MMFs might be systemically important when subject to important runs. We however advocate for a legislative response which is proportionate to the risks involved and which would preserve the availability of MMFs. Access to MMFs is important not just for European businesses but for organisations such as charities seeking to invest cash in a highly liquid and low risk medium.
The EACT supports a stable financial sector that meets the essential service requirements of the real economy. As a result of the financial crisis, an unprecedented regulatory overhaul of the financial system has been and is still underway. Whereas many of these measures are necessary in order to stabilise the financial system, it is becoming increasingly clear that some have major impact and unintended consequences for the real economy as the end-users of financial services.
Money Market Funds are an important cash management tool for businesses: these need to be able to deposit their short-term cash balances whilst strictly adhering to the principle that security (lowest level of risk) is paramount, followed by liquidity (fast access to cash by liquidating the investment) and then followed by yield. In the current very low interest rate environment yield is of very limited importance and certainly subordinate to security and liquidity.
The use of MMFs is not limited to the commercial sector; in many Member States investment of surplus funds in MMFs is a key activity for charities public as well as ‘third’ sector organisations. For all these economic actors MMFs have historically offered minimum risk, good access to cash and acceptable returns.
It is our view that there is one fundamental flaw in the Commission’s proposal. This concerns the removal of external credit ratings [section 2.1 below]. We are also concerned that by introducing what is in effect an obligatory requirement for a capital buffer to be held by Constant Net Asset Value (CNAV) funds the proposal will eliminate the CNAV product, which for some participants in the real economy is an acceptable and important investment medium [section 2.2 below]. Taking these two points together MMFs will lose their role in cash management. We believe that the overall result will have a damaging impact on the real economy and increase rather than decrease financial systemic risk [section 2.3 below].
There appears to be a fundamental error in the Commission’s articulation of the issues around the use of credit ratings. The Regulation rightly stresses the need for an MMF to be rigorous in its assessment of the credit quality of instruments in which it plans to invest (Recital 29). We support the Commission in this view, even though it stretches credulity to imply (as the Commission does) that without regulatory action an MMF might in some way be casual about the risks of the investments it makes.
The proposal then makes an unexplained (and inexplicable) leap from its view on the need for internal rigour in risk assessment to introducing a bar on MMFs soliciting or paying for a rating by a credit rating agency (Article 23).
Investors in MMFs appreciate the oversight provided by independent ratings and incorporate external ratings criteria in their internal policies and controls; ratings then act as a filter to weed out completely inappropriate funds. Investors do this because it is impossible for them to support internally the standard of credit analysis undertaken by credit rating agencies. Sound corporate governance requires that the investment of an organisation’s assets – and especially financial assets such as cash – is safeguarded as far as possible by processes that are robust and externally verifiable, rather than wholly dependent on subjective internal judgment as the Commission proposal appears to suggest. Ratings very effectively support this governance principle.
The description above applies to organisations of all sizes within the real economy and in at least some Member States. It is especially true of SMEs, charities and public or third sector bodies. In the absence of ratings it becomes effectively impossible for these organisations to invest in MMFs because the scale of the analysis would be too large. Whilst this outcome may be welcomed by some, the legislators need to reflect on whether the resultant concentration of short-term investable liquidity in a small number of acceptably rated banks globally is desirable and whether this actually increases global systemic risk.
The Commission’s proposal seizes on the legislative drive to reduce dependence on ratings – the principles of which we support – whilst at the same time failing to understand how ratings are actually used by the real economy. MMF ratings help to reduce risk and therefore play their own vital part in supporting the growth objectives of the EU. If the soliciting of credit ratings was to be prohibited, real economy users of MMFs would need substantial time to adjust their internal policies and practices and therefore the assessment of the appropriateness of a limitation on the use of credit ratings should be deferred to the review of the Regulation.
We strongly urge the legislators to delete Article 23 and add an additional sub point to Article 45 as follows:
(f) assess the possibility of limiting the use of credit ratings by MMFs and its impact on MMF investors
The regulation introduces (Article 29) a requirement for CNAV funds using amortised cost accounting to hold a 'NAV buffer’ of 3%. No such requirement is imposed on VNAV funds. This proposal is made as a necessary and sufficient measure to protect investors against 'run risk’ in CNAV funds. As a proposal it ignores the more measured approach being taken by authorities in the United States, who are focusing on rules and processes (such as liquidity gates) that institutionalise protection against run risk without imposing capital requirements on MMFs.
The MMF industry has clearly shown in its responses to the proposal that the cost of such a capital buffer renders CNAV funds unviable, not just in the current interest rate environment but also in any reasonably foreseeable change in that environment. It is expected that in response CNAV funds will be converted to VNAV funds. Whilst VNAVs are widely used in many Member States, in others the investment policies pursued by such funds – and the absence of a stated commitment to maintain a fixed value – renders the funds unacceptable for real economy participants that refuse to take such risks with short-term cash balances.
A further adverse consequence arises from uncertainty about whether VNAV MMFs would in all Member States qualify for accounting treatment as ‘cash or cash equivalent’. The alternative – which is that VNAV funds are classified as short term investments on companies’ balance sheets – would make such investments even more unattractive in those Member States where the accounting treatment is more rigorous. If companies nonetheless invested in VNAV MMFs this could potentially have an adverse impact on their own credit ratings, as the investor perception would be that the companies involved are now more risky as a result of holding less free “cash” than before.
The Commission appears to believe that run risk is an issue but that it is only an issue for CNAV funds (as no proposals are made that would result in a requirement to hold capital buffers for VNAV funds). There is no logic in this approach unless it is simply seen reflecting an intention on the Commission’s part to eliminate CNAV funds by whatever means possible.
There are some real economy participants who consider that run risk is at least as great an issue for VNAV as for CNAV funds. Those users of MMFs who take this view are content to rely on their own internal management controls and on external credit ratings to monitor and minimise this risk as far as possible. If the legislators are convinced by the argument that MMFs create systemic risk (which we are not) the logically the same approach to capital buffers should apply to VNAV as to CNAV funds.
We believe that a more appropriate approach to reducing the perceived risk in both CNAV and VNAV funds is to require better disclosure and transparency; we would also support adoption of some of the elements seen in the US, such as liquidity gates and liquidity fees. The latter address run risk both by making withdrawals difficult and by placing the cost of withdrawals unequivocally with the investors involved rather than with all the MMF’s investors.
We strongly urge the legislator to make the following amendments:
| o Revised Article 29 (could also be new Article 37(6) in the transparency section): "A CNAV MMF other than a Government Liquidity CNAV MMF [Government Liquidity MMF: a MMF which aims to achieve its investment objective by investing its assets in the highest quality securities issued or guaranteed by governments, supranational or public international bodies and may enter into reverse repurchase agreements (cash investments) which are collateralised with the same high quality securities on a short term basis] or manager of a CNAV MMF other than a Government Liquidity CNAV MMF shall publish on at least a weekly basis the mark-to-market price of the CNAV MMF and the proportion of weekly maturing assets of the CNAV MMF" | |
| o Revised Article 30: "A CNAV MMF other than a Government Liquidity CNAV MMF or manager of a CNAV MMF other than a Government Liquidity CNAV MMF shall impose a 1% redemption fee if the proportion of weekly maturing assets of the CNAV MMF falls below 10%. A CNAV MMF other than a Government Liquidity CNAV MMF or manager of a CNAV MMF other than a Government Liquidity CNAV MMF may impose a temporary suspension of redemptions to facilitate the introduction of such a fee. The proceeds from the redemption fee shall be invested in the CNAV MMF to the benefit of remaining shareholders. If, after 30 days, the liquidity of the CNAV MMF is not repaired, the CNAV MMF shall be liquidated" |
We make the point above that the bar on credit ratings (Article 23) will make it impossible for most real economy organisations to invest in MMFs, whether these are CNAV or VNAV.
We also identify that in those member states where CNAV funds are currently acceptable but VNAV funds are not, the conditions imposed by the Commission’s proposal (Articles 30 and 31) will have the effect of eliminating the CNAV product. This essential tool for real economy cash management will be closed off and many CNAV investors will not be willing to switch to VNAV funds.
The Commission has itself admitted (FAQ 14 of the FAQ document supporting its regulatory proposal 1 ) that if CNAV investors removed their funds from the sector “This could [therefore] have some negative repercussions on the entities that rely on the MMFs to get their funding”. The Commission uses this as an argument to support the capital buffer approach but in doing so ignores the fundamental issues of viability (let alone the issue of the loss of credit ratings).
We consider that the proposed Regulation will result in the following scenario:
We suggest that the legislators need urgently to take account of the flaws in the regulatory proposal as well as likelihood of the scenario described above. [[[PAGE]]]
As the debate about the EC’s proposed Money Market Fund Regulation enters a new phase, the IMMFA has released a collection of papers which explain the background to their position on the key issues, which can be seen at www.treasury-management.com/IMMFA
A summary of the IMMFA views is given below.
Investors: Corporations, pension funds and other institutional investors have vast liquid portfolios. They are not protected by government guarantee schemes and are very risk sensitive. They value MMFs for their credit diversification, access to professional credit management, transparency and the efficiencies they provide their day-to-day operations. In addition, the MMF assets are held in third party custodians and are not exposed to the insolvency of the MMF provider.
Issuers: CNAV MMFs provide a small but relatively stable source of cross-border funding for European banks and, to a lesser extent, companies. This funding is important given the challenges facing European banks as they deleverage coupled with the volatility and increasingly national profile of the interbank lending market.
European companies: MMFs represent approximately 50% of all investments in Asset Backed Commercial Paper (ABCP) in Europe. ABCP improves the working capital of large companies such as Telecom Italia, Lafarge and Volkswagen. However, over 50% of the recipients of this funding are SMEs and non-rated firms that have limited direct access to capital markets, particularly in countries where banks are finding it increasingly difficult to lend to such firms. Some ABCP conduits benefit from supranational guarantees, demonstrating their importance to the economy.
Many regulators have concluded that MMFs did not cause the financial crisis in 2007/2008.
The November 2012 SEC staff report on MMF states that academic literature characterises redemptions from MMFs as a ‘flight to quality’ as many investors switched their bank credit exposure in prime MMFs into sovereign risk in Government Liquidity MMFs. Nervous investors reduced their exposure to bank credit during the 2008 credit crisis whether they were invested in MMFs, had money on deposit with banks or invested directly in bank debt instruments.
Nevertheless regulators remain concerned over the role MMFs played in transmitting the financial crisis via client redemptions and sponsor support. IMMFA recognizes these concerns and supports many of the provisions of the EC MMFR proposal, including that MMFs should have:
IMMFA believes that redemption gates and fees will be more effective in mitigating client redemptions than capital requirements (the European Commission’s proposal).
Redemption gates and/or liquidity fees would act as a ‘circuit breaker’, reducing client redemptions during stressed market conditions. A redemption gate and/or liquidity fee would dis-incentivise investors from irrational flight. Clients who truly need liquidity to meet specific payments or clients who decide they want their cash could access it, but they would need to pay a redemption fee for this access in order to keep whole those investors that stay invested in the MMF. This would be equivalent to the decrease in value an investor ii would face if they were invested in a VNAV fund or if holding the debt instruments directly. Such a fee would create the opposite incentive to a first-mover advantage. The majority of CNAV MMFs already explicitly provide in their fund prospectuses for the ability to charge liquidity fees and full or partial gates. With a couple of notable exceptions, these powers were generally not used during the 2007/8 financial crisis as MMF managers feared the client reaction were liquidity funds (MMF) not to provide liquidity - redemption gates and liquidity fees endorsed by regulation would remove this stigma effect.
In contrast, capital will not address client ‘runs’ in a systemic crisis
Capital does not address the issue of a ‘run’ on a MMF (aka the bank debt held in a MMF). It might make a MMF more robust in times of modest stress but will be insufficient in times of systemic market stress. IMMFA appreciates Commissioner Barnier’s explicit desire not to prohibit one type or other of MMF given the importance of MMF to the European economy. Nevertheless, the requirement for CNAV MMF to provide 3% capital amounts to such a prohibition as 3% capital is very far from being economically viable for MMF managers. The provision of such a capital buffer, were it economically feasible, would withdraw circa euro 200bn - 250bn from the European economy.
4 The EC proposal for a 3% capital buffer is of a different order of scale to IOSCO’s recommendation of an NAV buffer designed to compensate for the difference between the MMF’s NAV (price of 1:00) and the shadow market price (generally within a range of 99.97 to 100.03)
5 The assets under management of CNAV MMFs in Europe are slightly under euro 500bn. Applying 3% capital would require euro 10bn from European bank sponsors. As banks are geared typically between 20 and 25 times, the reduction in lending to the European economy would be in the order of euro 200bn – 250bn.
6 Fitch Comments on EC’s Proposed Regulatory Changes to Money Market Funds, 11 September 2013.
7 Amortised cost accounting is accepted by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) as a proxy for ‘fair value’. It is consistent with the accounting treatment of bank assets that are bought with the intention of holding them to maturity (FRS 5 and UFRS 9).
8 A recent study by independent fund administrators of IMMFA funds revealed that between 90% and 100% of MMF assets are priced using “evaluated prices” rather than traded or quoted prices.
The objective of both CNAV and VNAV Short Term MMFs is to provide investors with security of capital and high levels of liquidity. There is no material difference between the underlying assets and therefore no greater susceptibility of runs in one type of fund or the other. A recent Fitch report [6] stated that approximately 20% of French VNAV MMFs and 30% of CNAV MMFs suffered monthly outflows of 20% or more in September and October 2008.
IMMFA believes that amortisation is an appropriate method to value assets in a MMF as MMFs buy and hold to maturity very high quality, short term assets (with typical terms of less than 90 days) most of which do not have traded market prices8 and which mature at par. Alternative methods such as mark-to-market or mark-to-model are not superior. Indeed, requirements to reference market prices exacerbated issues during the 2007-2008 financial crisis. This is important as one of the key features of MMF for investors is the ability to access cash ‘same day’ – something we believe is not operationally feasible with mark to model or market to market pricing based on independent third party pricing.
The EC’s MMFR proposal will have unintended impacts on investors, issuers and financial stability
IMMFA suggests the following amendments to the European Commission’s (EC) MMFR proposal.
1. Capital requirements for CNAV MMF (Articles 29 - 34). Replace the capital requirements for CNAV MMF with a regulatory requirement to implement redemption gates and fees. IMMFA strongly believes that gates and fees coupled with liquidity buffers and enhanced transparency will be most effective in mitigating client redemptions from MMFs. Gates and redemption fees also preserve the utility of CNAV MMFs for investors and thus the size of European short-term funding markets.
2. Government Liquidity CNAV MMFs. Exempt Government Liquidity MMFs from the requirement to implement gates and fees as, in times of financial market stress, investors do not ‘run’ from but to such MMF. Again, this preserves the utility of such MMF for investors and funding for European governments.
3. Valuation of MMF’s assets (article 26). Allow VNAV MMF to value securities by mark-to-market, mark to model or (for securities under 60 days) by amortisation. This latter provision is consistent with the SEC MMF proposal and accords with the IASB ‘true and fair’ provisions. Other methods based on Libor and Euribor yield curves will introduce artificial volatility and fail when no market prices exist.
4. External Data Sources. Pricing data should be provided by recognised independent pricing vendors. Any model used in ‘mark-to-model’ pricing should be reviewed and approved by ESMA.
5. Fund level ratings (Article 23). Replace current provisions prohibiting MMF managers from seeking fund level ratings by a requirement to review three years after the entry into force of the MMFR the confidence of investors in the MMFR and whether conditions are such that MMF managers can then be prohibited from seeking fund level ratings. Fund level ratings allow investors to identify comparable MMFs on which to carry out further due diligence prior to their final investment decision. The investment guidelines of most investors in CNAV MMFs require MMFs to be rated by at least one CRA. This will allow investors time both to gain confidence in the MMFR and where appropriate to adjust their investment guidelines.
6. Credit quality of money market instruments (Articles 16 to 20). Replace current provisions and align with the requirement of IOPRs, UCITS and AIFs to carry out their own internal analysis and monitoring which must not be mechanistic.
7. Eligible securitisations (Article 10). IMMFA recommends that the provisions be amended so that ABCP conduits with both corporate and consumer receivables qualify as eligible securitisations. This will permit ABCP to continue to improve the working capital of European companies, especially SMEs and non-rated companies. The current provisions allow investment in ABCP conduits that have exposure solely to corporate consumer receivables. This effectively eliminates ABCP as an asset class for MMFs as only one such conduit exists in Europe. It also does not reflect the reality that consumer assets have a better credit track record in Europe than corporate assets.
8. Definition of daily and weekly maturing assets for short-term MMFs (Article 21). Amend the provisions to include a wider range of very highly liquid government and agency securities that are easy to buy and sell at short notice. The current definition is unnecessarily restrictive in this regard.
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